Chapter 11: Theory of

financial structure

Financial Markets and Inst

itutions Chapter 11

The Puzzles of the Financial

Structure
Why stocks are not the most important source of external financing for
business?
Why issuing marketable debt and equity securities is not the primary
way in which businesses finance their operations?
Why indirect finance, which involves the activities of financial
intermediaries, is many times more important than direct finance, in
which businesses raise funds directly from lenders in financial
markets?
Why Banks are the most important source of external funds?
Why the financial system is among the most heavily regulated sectors
of the economy?
Why large, well established corporations have access to securities
markets to finance their activities?
Why collateral is a prevalent feature of debt contracts?
and, why Debt contracts are typically extremely complicated legal
documents?
Financial Markets and Inst
itutions Chapter 11

Transactions Costs
Costs associated with financial transactions
between lenders to borrowers.
Costs from creating a contract when issuing
a loan or a security.
Costs from trading securities in the
secondary market.
Financial intermediaries reduce
transactions costs through expertise and
economies of scale
Financial Markets and Inst
itutions Chapter 11

Asymmetric Information
Borrowers usually know more about their
expected profitability and their likelihood of
default than lenders.
Adverse Selection
Before transaction occurs
Potential borrowers most likely to produce
adverse outcomes are ones most likely to seek
funds.
Financial intermediaries develop expertise at
evaluating, or screening, potential borrowers.
Financial Markets and Inst
itutions Chapter 11

EXAMPLE
1. Assuming that a used car dealer knows exactly

the quality of the following three cars: A, B, C,

and prices them accordingly: $8,000 for A,
$9000 for B, $10,000 for C.
On the other hand, you don't know EXACTLY
the quality of each car but you know the
AVERAGE price, based on the Blue Book, Car
Magazine, etc., of these cars are $9,000.
How much will you be willing to pay for the car
(you need one car only)? What he/she will do if
you insist to pay for $9,000?
Financial Markets and Inst
itutions Chapter 11

Markets and Asymmetric Information

1. Differences in information can affect how well markets
function. For example, the car dealer example shows
that if we as consumers are willing to pay the average
$9000, then the "rational" car dealer will withdraw the
$10,000 car from the market. The would-be customer,
after figuring this out, are now willing to offer $8,500
for each car. But at this price, the car that is worth
$9,000 will also be withdrawn from the market and the
only car left for sale will be the $8,000 "lemon".
Thus when one side of the market is less well
informed than the other side, trade may be severely
inhibited.
Financial Markets and Inst
itutions Chapter 11

Tools to Help Solve Adverse

Selection Problems
Private Production and Sale of Information
In addition to the high transaction costs, private
production of information is necessary to solve the
problem of asymmetric information. The free-rider
problem suggests that the private sale of information
will be only the partial solution to the lemon problem
Government Regulation
The government could produce the information to help
investors distinguish good from bad firms and provide it
to the public free of charge. SEC is the government
agency that requires firms selling their securities in
public markets to adhere to standard accounting
principles and to disclosure information about their
sales, assets and earnings.
Financial Markets and Inst
itutions Chapter 11

Tools to Help Solve Adverse

Selection Problems
Financial intermediation
A financial intermediary such as a bank becomes an expert in
the production of information about firms so that can sort out
good credit risks from bad ones.
The better known a corporation is, the more information about
its activities is available in the marketplace. The larger and more
mature a corporation is, the more information investors have
about, and more likely investors will be willing to invest directly
in its securities

Collateral and Net Worth

Net worth (also called equity capital) the difference between a
firm`s assets and liabilities can perform the similar role to collateral.
Financial Markets and Inst
itutions Chapter 11

Asymmetric Information
Moral Hazard
After transaction occurs
Hazard that borrower has incentives to engage in
undesirable, or immoral, activities making it more likely
that the borrower will default.
What leads the incentives of the borrower and lender to
be different, or incompatible? The answer is: the
separation of ownership and control - The Principal-Agent
Problem.
The stockholders, who own the firm (the Principals), are
not the same people as the managers, who run the firm
(the Agents). Because the agent has more information
about their activities than the principal there will be an
informational asymmetry - or Moral Hazard
Financial Markets and Inst
itutions Chapter 11

Tools to Help Solve Adverse

Selection Problems
Production of Information : Monitoring
Auditing the firm frequently and checking on what the
management is doing
Internal control mechanism (Board of directors,
internal auditors)
External control mechanism (SEC, External auditors;
Bondholders and lenders (banks); Financial analysts
and credit rating agencies)

Government Regulation
SEC is the government agency that requires firms
selling their securities in public markets to adhere to
standard accounting principles and to disclosure
information about their sales, assets and earnings.
Financial Markets and Inst
itutions Chapter 11

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Tools to Help Solve Adverse

Selection Problems

Financial intermediation
One financial intermediary that helps reduce the moral
hazard arising from principal agent problem is the
venture capital firm. Venture capital firms pool the
resources of their partners and use the funds to help
budding entrepreneurs start new businesses. In
exchange for the use of capital, the form receives an
equity share in the new business.

Debt Contracts
As legal restrictions on debt contracts reduce the need
to monitor activities, the issue of moral hazard explains
puzzle 1, why stocks are not the most important source
of financing for businesses.
Financial Markets and Inst
itutions Chapter 11

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